Openness in the financial markets

Question 1

What are the 2 components of the financial market in an open economy?

Answer 1

• The money market
• The bonds market

Question 2

What is the money market?

Answer 2

Determining how much money vs bonds people hold

Question 3

What is the bonds market

Answer 3

Determining how much foreign bonds vs domestic bonds people hold

Question 4

What is the equilibrium in the money market?

Answer 4

M/P = YL(i)
This is the same as in an closed economy

Question 5

What is the equilibrium in the bonds market?

Question 6

What is the IS - LM model in an open economy

Answer 6

The IS: Y = C(Y-T) + I(Y,i) + G + NX(Y, Y, Interest parity equation)
The LM: i = i

Question 7

in the open economy IS - LM model what effect does an increase interest rate have?

Answer 7

• The direct effect of investment
• The secondary effect of an increase in nominal exchange rate

Question 8

Why is the IS curve downward sloping?

Answer 8

Because an increase in the interest rate will lead to a drop in investment

Question 9

What is expansionary fiscal policy?

Answer 9

A policy that has the objective to increase aggregate demand

Question 10

What happens on the IS - LM graph in expansionary fiscal policy

Answer 10

An increase in gov spending, will cause the IS curve to shift rightwards which in-turn will increase output, through a multiplier effect

Question 11

What does expansionary fiscal policy cause

Answer 11

• Increase in demand, leading to an increase in output
• Consumption and government spending both increase
• Investment increases
• Net exports decrease

Question 12

What is Contractionary Monetary Policy

Answer 12

A policy with the objective to increase interest rates, normally because the economy is growing too fast, creating inflation

Question 13

What happens on the IS - LM graph in contractionary monetary policy

Answer 13

• Increase in interest rate will cause the LM curve to shift upwards, which will lead to lower equilibrium output
  -An increase in interest rate will also lead to an increase in the nominal exchange rate

Question 14

Given the expected future exchange rate and the foreign interest rate, an increase in
the domestic interest rate leads to an increase in the exchange rate. T or F?

Answer 14

TRUE - The Interest Parity Relation suggests that given the expected future exchange rate and the foreign
interest rate, an increase in the domestic interest rate should increase the exchange rate leading to an
appreciation. When domestic interest rates increases, it makes domestic financial assets relatively
more profitable. Investors who would like to hold more domestic assets demand domestic currency
leading to an appreciation.

Question 15

It is possible to have a real exchange rate appreciation and a nominal exchange rate
depreciation at the same time. T or F

Answer 15

TRUE - Yes, a nominal exchange rate depreciation is a decrease in E. If at the same time, domestic prices
are increasing much faster relative to the foreign prices, then P/P∗
could increase to swamp the
decrease in E so that = EP/P∗
increases, i.e., a real exchange rate appreciation.

Question 16

A decrease in government spending and a real depreciation is the right policy mix to
improve the trade balance without changing the level of domestic output. T or F

Answer 16

TRUE - A real depreciation improves the trade balance since it makes foreign goods more expensive relative
to domestic goods, leading to an increase in net exports. But such an increase in net exports implies
an increase in domestic output. The government can then decrease its spending to offset the resulting
increase in output.